Last week we discussed what exactly an initial election is under the Check the Box regulations. We barely touched on what constitutes a change in classification under the CTB regulations. However, on face value alone it did not look as if it seemed simpler than an initial election, right?
Well, if you read this article, it might just be.
While typing the above sentence I was trying my best not too sound like the narrator of your favorite reality television show, where the only part you want to see or in this instance read, is left until the very last scene or paragraph.
Luckily for the reader, this blog is not funded by commercials. I have no need to drag it out to the very last sentence so that all the companies who paid the network for airing their commercials are televised.
So, let us discuss a bit more in detail what is a change in classification election for US Federal tax purposes and why it is important for any business owner to understand this type of change.
As the CTB regulations rightly stipulates, elective classification changes are transactions without actual form. In layman’s terms, an elective classification change is possible without changing the legal form of the business entity itself.
In terms of the regulations, an elective change is treated as triggering one or more deemed transactions, which differ depending upon the reclassification that takes place. The tax implications and treatment of an elective change is determined under all relevant provisions of the Internal Revenue Code. This includes the step-transaction doctrine. The step-transaction doctrine ensures that the tax consequences of an elective change will be “identical” to the tax consequences if a taxpayer had actually taken the steps described in the regulations.
THE IMPLICATION OF AN ELECTIVE CHANGE DEPENDS ON YOUR BUSINESS ENTITY
It is important to keep in mind that there is no “one shoe fits all” rule when it comes to changing the classification of your business entity. The implications, or should I rather say “deemed” implications, differ depending on what the initial entity was classified as and what it will be changed to.
Elective change of a Partnership to an Association –
When an eligible entity which is initially elected to be classified as a partnership elects to change its classification to an association, it will be deemed that the partnership contributes all of its assets and liabilities to the association in exchange for stock. Immediately afterwards, the partnership liquidates by distributing the association’s stock to the partners.
Elective change of an Association to a Partnership –
Similar as above, but from an association to a partnership will deem the association to distribute all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders will contribute all of the distributed assets and liabilities to a newly formed partnership.
Elective change of an Association to a Disregarded Entity –
If an association elects to be disregarded as an entity separate from its owner, the association will be deemed to have distributed all of its assets and liabilities to the single owner in liquidation of the association.
Elective change of a Disregarded Entity to an Association —
If a disregarded entity separate from its owner elects to be classified as an association the owner of the entity will be deemed to contribute all of the assets and liabilities of the entity to the association in exchange for the stock. under paragraph (c)(1)(i) of this section to be classified as an association, the following is deemed to occur: The owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.
At this stage of the blog, the emphasis for the reader should be on the word “deemed”. The election change of an entity might be a proactive step taken by the owner, but it automatically deems certain tax implications to occur. Further, once an elective change has been made in terms of the CTB regulations, there is a waiting period of 5 years, before you can make another elective change.
THE DUCK TEST
Those of you who are not familiar with the Duck Test, this is a basic concept stipulating that if it walks like a duck, swims like a duck, and quacks like a duck it probably is a duck.
The CTB regulations do a great job in phrasing certain options available to a taxpayer so that it seems harmless. By way of example – “Change of entity classification”.
I don’t know about you, but I’m really struggling to see the word tax in that phrase.
Remember, if it acts like a tax authority, drafts regulations like a tax authority, collects tax like a tax authority, and enforces tax legislation like a tax authority: it probably is a tax authority.
The CTB regulations are enforced by the IRS, so there will always be tax consequences somewhere in the fine print.